Capitalized Interest and Cash Flow From Operation

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milan1126

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Hi Buddies! Can anyone explain the question below in the Mock Exam 1 morning session? My understanding is if you try to expense a previously capitalized expense. It will reduce the depreciation cost while increase the interest expense since it is expensed immediatly at one time. The total effect should be reducing the CFO while increasing CFI. Is there anything wrong with my understanding here? Thanks!

Note 11. Property and Equipment
Depreciation expense for 2013 and 2012 was $388 and $362, respectively. These amounts include capitalized interest of $34 and $143, respectively.
Interest is allocated and capitalized to construction in progress by applying the firm’s cost of borrowing rate to qualifying assets. Interest capitalized in 2013 and 2012 was $66 and $170, respectively.

Ignoring the effects of income taxes, the expensing of previously capitalized interest, Note 11, most likely causes Piezo’s cash flow from operations to be:
A. lower.
B. unchanged.
C. higher.

Answer = B
The expensing of the previously capitalised interest is a non-cash amount (the cash outflow was in a previous period when the expense was incurred) and therefore does not affect operating cash flow. Net income is lower as a result of the previously capitalized amount being expensed, but as it is a non-cash expense it is added back to determine cash from operations. (Lower net income but higher add back = no change in CFO).
 
Hi,
The total effect is zero. What we do is just reclasslfying CF (from CFI to CFO) with the result of a lower CFO:
adj CFO: - capitalized int
adj CFI: + capitalized int
Total effect: 0
 
Yeah, this is also my understanding. But the question is asking the effect on CFO. The answer is unchanged.
 
Sorry, we are talking about the PREVIOUSLY capitalized interest, this means the cash outflow was last year and does not affect this year’s CF (nor CFO nor CFI).
 
Hello Milan,
This confused me a lot as well.
What I gathered from this question is that they asked for the effect of expensing previously capitalized interest on the CURRENT year CFO. Since the interest was capitalized in prior years, expensing them now would lead to:
+ Interest expense and - Net Profit on the Current year’s P&L and
N.I + Interest Expense (representing prior year capitalized interest) on the Current year’s Cash Flow statement (No change)
You understand?
 
Hi,
I thought in this way as well by treating the expense as expense in Previous Years then it should have no impact on current year’s cash flow from operation. In this way, the capitalized interest would not exist in current year. Then the answer is correct.
However, in the explanation part of the answer, it says”Net income is lower as a result of the previously capitalized amount being expensed”, which is confusing again. Since the capitalized interest(included in depreciation cost) should be removed current year’s expense, the net income should be higher.
What do you think?
 
Thanks for your answer. I replied Lucky_27 in the previous post. He is basically expressing similar idea with you in my opinion.
 
You’re welcome.
Remember the interest expense would more than offset the depreciation adjustment in the current year, so N.I will still be lower.
Graeme
 
Sorry that I am still confused. The interest expense should be expensed in the previous year in your interpretation. Otherwise interest expense will reduce CFO in current year.
We currently have two interpretations now:
1. Current year’s capitalized interest is expensed in current year. Then both CFO and Net Income should reduce.
2. The capitalized interest in current year actually results from capitalizing an expense in previous year. Then the interest expense should occur one time in previous year and CFO in current year will not be affected. The reduction of CFO and NI happened in previous year, while in current year since the capitalized interet is removed, NI should be higher.
 
Capitalized interest 2012: 170 (thereof depreciated in 2012: 134)
If we don’t adjust the I/S 2012, there would be 170-134=36 depreciation “left” for 2013.
By expensing capitalized interest, we adjust dep (-36) and interest exp (+36), total effect on NI: 0
CF = NI + NCC (-36+36=0) = NI + 0
 
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